1. Unit 3: Aggregate Demand and Supply and Fiscal Policy1

2. Review
Explain how to show full employment, inflation, and unemployment on the PPC.
Explain how to show full employment, inflation, and unemployment on the Business Cycle.
Draw an Inflationary Gap with your elbow.
Draw a Recessionary Gap with your foot.
Explain why the economy is like a car.
Identify what Congress can do to put on the brakes.
Identify what Congress can do to put on the gas.
Explain the difference between discretionary and non-discretionary Fiscal Policy.
Name 10 Universities outside California. 2

3. they should NOT spend 100 billion!
What type of gap and what type of policy is best?
What should the government do to spending? Why?
How much should the government spend?
The government should increasing spending which would increase AD, but
they should NOT spend 100 billion!
If they spend 100 billion, AD would look like this:
LRAS AS
Price level
WHY? P1
AD2
AD1
$ $500
Real GDP (billions) FE

4. The Multiplier Effect
Why do cities want the Superbowl in their stadium?
An initial change in spending will set off a spending chain that is magnified in the economy.
Example:
Bobby spends $100 on Jason’s product
Jason now has more income so he buys $100 of Nancy’s product
Nancy now has more income so she buys $100 of Tiffany’s product.
The result is an $300 increase in consumer spending
The Multiplier Effect shows how spending is magnified in the economy.

5. Effects of Government Spending
If the government spends $5 Million, will AD increase by the same amount?
No, AD will increase even more as spending becomes income for consumers.
Consumers will take that money and spend, thus increasing AD.
How much will AD increase?
It depends on how much of the new income consumers save.
If they save a lot, spending and AD will increase less.
If they save a little, spending and AD will increase a lot.

6. Marginal Propensity to Consume
Marginal Propensity to Consume (MPC)
How much people consume rather than save when there is an change in income.
It is always expressed as a fraction (decimal).
Change in Consumption
Change in Income
MPC=
Examples:
If you received $100 and spent $50.
If you received $100 and spent $80.
If you received $100 and spent $100.

7. Marginal Propensity to Save
Marginal Propensity to Save (MPS)
How much people save rather than consume when there is an change in income.
It is also always expressed as a fraction (decimal)
Change in Savings
Change in Income
MPS=
Examples:
If you received $100 and save $50.
If you received $100 your MPC is .7 what is your MPS?

8. Because people can either save or consume
MPS = 1 - MPC
Why is this true?
Because people can either save or consume 8

9. How is Spending “Multiplied”?
Assume the MPC is .5 for everyone
Assume the Super Bowl comes to town and there is an increase of $100 in Ashley’s restaurant.
Ashley now has $100 more income.
She saves $50 and spends $50 at Karl’s Salon
Karl now has $50 more income
He saves $25 and spends $25 at Dan’s fruit stand
Dan now has $25 more income.
This continues until every penny is spent or saved
= Multiplier x
Total change in GDP
Initial Change
in Spending

10. Calculating the Spending Multiplier
If the MPC is .5 how much is the multiplier?
Spending
Multiplier OR
If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP?
How much will a decrease of $3 in spending decrease GDP?
MPC = .5 the multiplier is 2
= Multiplier x
Total change in GDP
Initial Change
in Spending 10

11. The Multiplier Effect
Let’s practice calculating the spending multiplier
Spending
Multiplier OR
If MPC is .9, what is multiplier?
If MPC is .8, what is multiplier?
If MPC is .5, and consumption increased $2M. How much will GDP increase?
If MPC is 0 and investment increases $2M. How much will GDP increase?
Conclusion: As the Marginal Propensity to Consume falls, the Multiplier Effect is less

12. Fiscal Policy Practice
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8)
LRAS
What type of gap?
Contractionary or Expansionary needed?
What are two options to fix the gap?
How much initial government spending is needed to close gap? AS
Price level P1
AD2
AD1
$100 Billion
$ $1000FE
Real GDP (billions)

13. Fiscal Policy Practice
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5)
LRAS
What type of gap?
Contractionary or Expansionary needed?
What are two options to fix the gap?
How much needed to close gap? AS P2
Price level
-$10 Billion
AD1 AD
$80FE $100
Real GDP (billions)

14. What about taxing? Expansionary Policy (Cutting Taxes)
The multiplier effect also applies when the government cuts or increases taxes.
But, changing taxes has less of an impact than government spending. Why?
Expansionary Policy (Cutting Taxes)
Assume the MPC is .75 so the spending multiplier is 4
If the government cuts taxes by $4 million how much will consumer spending increase?
NOT 16 Million!!
When they get the tax cut, consumers will save $1 million and spend $3 million.
The $3 million is the amount magnified in the economy.
$3 x 4 = $12 Million increase in consumer spending

15. Calculating the Tax Multiplier
If the MPC is .75 how much is the tax multiplier?
MPC
MPS
Simple Tax
Multiplier
If the spending multiplier is 4, then the tax multiplier is only 3
But remember that an increase in taxes decreases GDP. (vice versa)
MPC = .5 the multiplier is 2
= Tax Multiplier x
Total change in GDP
Initial Change
in Taxes 15

16. Cutting Tax Practice $10 Billion Price level $20 Billion
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5)
LRAS
1. What to options does the government have?
2. How much should they increase government spending?
$10 Billion
3. How much should they cut taxes? AS
Price level P1
AD1
AD2
$20 Billion
$ $100FE
Real GDP (billions) 16

17. Multiplier Effect

18. Non-Discretionary Fiscal Policy

19. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers
Legislation that act counter cyclically without explicit action by policy makers.
AKA: Automatic Stabilizers
The U.S. Progressive Income Tax System acts counter cyclically to stabilize the economy.
When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD.
When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD.
The more progressive the tax system, the greater the economy’s built-in stability.

20. 2008 Practice FRQ 20

21. 2008 Practice FRQ 21